From Short to Medium Run (IS-LM-PC)

Quantitative Easing (QE) & Unconventional Policy

coreExam · medium

Quantitative easing: CB buys long-dated bonds and risky assets to compress term and risk premia when conventional rate cuts are exhausted (ZLB). Operates via three channels — signalling, portfolio balance, and credit. Evidence: QE lowered long-term yields by ~50–100 bp per round in 2008–15. Unwinding ('QT') is slower and ongoing.

Derivation

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When to Use QE

i = 0 \text{ (ZLB)} \implies \text{conventional policy ineffective}

CB cannot lower the short rate further. Needs tools that work through long rates and risk spreads.

Three Channels

| Channel | Mechanism | Target | |---------|-----------|--------| | Signalling | Commits CB to low rates | $r^{e'} \downarrow$ | | Portfolio balance | Reduces duration supply | Term premium $\downarrow$ | | Credit / risk spread | Buys risky assets | $x \downarrow$ |

The Balance Sheet

Fed balance sheet rose from ~5% of GDP in 2008 to ~35% by 2021. ECB similarly expanded via APP and PEPP. Post-2022: QT underway, gradually shrinking balance sheets alongside rate hikes.

Empirical Effects

| Programme | Period | Estimated yield impact | |-----------|--------|------------------------| | Fed QE1 | 2008–09 | ~100 bp on 10y Treasuries | | Fed QE2 | 2010–11 | ~50 bp | | Fed QE3 | 2012–14 | ~30 bp | | ECB APP | 2015–18 | ~50–80 bp on Bund |

Diminishing returns — first programmes larger effect; later ones smaller as markets anticipate.

Why Not Just "Printing Money"?

QE exchanges bonds for reserves. Private-sector portfolio composition changes, but total holdings of money + bonds is constant. Reserves don't circulate as transactions money. This is why QE did not cause high inflation 2008–2021 — despite massive balance-sheet expansion.

Post-2022 QT

Fed stopped reinvesting maturing bonds → balance sheet shrinks passively
No active sales to date (avoid market disruption)
Combined with rate hikes, a coordinated tightening

Worked Example

CB hits ZLB. Inflation below target. 10-year yield = 2%, risk spread x = 3%. Firms borrowing cost r + x = 5%.

Stage 1: Forward guidance commits rates low → 10y yield falls to 1.5% (~50 bp).
Stage 2: QE of 1 trillion Treasuries → term premium falls → 10y yield falls to 1% (~50 bp more).
Stage 3: QE including corporate bonds → x falls from 3% to 2%.
Net: firm borrowing cost r + x falls from 5% to 1% (new 10y) + 2% (new x) = 3%.

QE + forward guidance reduces firm borrowing cost from 5% to 3% despite the policy rate at 0. Key unconventional-policy channel at the ZLB.

Common Mistakes

—Confusing QE with 'printing money' to cause inflation — QE exchanges bonds for reserves, doesn't directly expand transactions money.
—Assuming QE always works — evidence suggests diminishing returns after QE1 and QE2.
—Forgetting that QE expands the CB balance sheet — reversed via QT with tightening effect.
—Ignoring fiscal/monetary interactions — QE buys government debt, blurring the fiscal-monetary line.

Exam Cues

→QE: CB buys long/risky assets when conventional rate cuts exhausted.
→Three channels: signalling, portfolio balance, credit/risk spread.
→Empirical: ~50–100 bp reduction in long yields per QE round.
→QT: reverse. Balance sheet run-off plus rate hikes in current tightening cycle.